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Facebook Stock Drops: What Really Goes On In IPOs

So by most accounts, the Facebook IPO is disappointing. Facebook’s stock ended its first day of trading a mere $0.23 above the deal price and today, Day 2, it has dropped more than 10% intraday. It was no accident it closed ever so slightly above the IPO price, but many investors don’t fully understand what is going on behind the scenes of an IPO, how banks might be betting against them, and the problems that arise when a stock trades below its IPO price.

So first things first: The Facebook IPO is only disappointing from a deal perspective – it is too early to pass judgment on whether it is a disappointment as an investment. Many great investments don’t have the most auspicious beginnings, while others might jump 50% on the first day of trading, only to flame out later. In other words, don’t judge the stock on one day of trading. The next Google or Apple rarely comes with the hype that they are the next Google or Apple. Facebook’s lack of a first-day trading pop creates a host of headaches for the dealmakers, funds that were looking for a quick profit, and perhaps some people at Facebook.

FB went public at $38 and spent most of the day in the $40-$42 range. Then, in the afternoon, the shares were met with heavy selling. Why did the stock sell off? Though there’s no way of knowing exactly why, it is fair to say that one key driver is quick profit-taking. If you are a mutual fund or hedge fund and had a million shares allocated to you in the deal, and could sell those for a quick $5 million profit, you might be smart to do so. The annualized return is staggering.

But why did FB shares close ever so slightly above the deal price on Day 1? Banks in IPOs often support deals, especially in the final trading hours, in order to keep them from closing below the IPO price. In my opinion, this is something the SEC should focus on, as it is an area that is ripe for improved transparency to protect investors. For investors, the most important questions about how FB might trade over the next few weeks might just be “How many shares collectively do the banks own of the deal right now?” and “Are the banks net long or net short FB today?”

Banks Might Be Betting Against You

Very few investors realize that when a company goes public, the banks taking them public are often making trades on their own behalf, including shorting the very stocks they are taking public. Investment banks can short the companies that they take public – and they usually do. In fact, banks can take naked short positions in the companies they are taking public. In addition, banks can also buy shares of the companies they are taking public. What some term “stabilizing the market” may actually be creating a false sense of security.

It is all clearly expressed in the Facebook registration document and in almost every IPO document: underwriters may engage in transactions like shorting the stock, creating naked short positions, and even being long the stock. Know that they are doing this not to intentionally hurt investors, but in the hopes of creating a more orderly market. It might have the unintended consequence of doing just the opposite.

That is, individual investors might see a stock that went public staying at it’s IPO price at $38 and think that it represents the true market of investors, when in fact it does not.

So let’s see what typically happens. A company goes public and the bank that is leading the offering sells 10 million shares. With most offerings, the underwriters allow for a 15% “Green Shoe” or an extra number of shares to be sold. So for this example, the bank would be selling 10 million share + 15% of 10 million, or a total of 11.5 million shares. So on day 1, the bank sells more shares than it actually has, and creates a short position. Later in the day or weeks, the bank will cover the short position by buying the 1.5 million shares in the open market. Any shareholders who had a quick profit and were selling their shares, would meet with some demand from the bank.

But what happens when the shares drop, as they did with Facebook? Initially the shares went up, and the banks sell more shares than they have – meeting the demand for shares by over-selling the shares, creating a short position for themselves. They create this short position, knowing they will have to buy shares later in the day or week. If the stock drops a little from its highs, the bank can even make a profit on the short trade. Yes, the bank might be selling to you at $43, only to make money later in the day when the stock drops to $38.23, effectively betting against the investor they are selling to.

But if the stock continues to fall, the bank is faced with another dilemma – they need to stabilize the market and they start buying the shares. But how many shares can they buy? Do they cover their whole short position and then go long the stock? There is no proscribed limit. By buying the stock, the bank is doing its job of stabilizing the market, but it is also creating risk because then it owns a stock that can go down further. Like a finger in a dike, there is only so much a bank can do and is willing to do to stabilize a share price.

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these are not the IPO’s of the 90′s. People saw groupon, yelp, linkedin, angies list and some i forgot. they all went down so its my opinion people are not jumping at the sound of IPO. I do think people will jump on it but not til we find out what it is exactly. right now its just 1 big commercial

I am not sure what you mean by “back the stock.” As for the analysts and their reports, they won’t be out for a while. Generally, analysts are favorable toward deals, although with regulatory changes, the direct pressure to do so has been diminished. As for particular banks and whether they choose to buy stock in the aftermarket or not, that is really up to them.

It’s odd – some people live on it and others use it for birthday reminders only. My personal opinion is never to sign up for a social media site that owns your data and won’t let you take it down/eliminate it/close access to your account when you want to.

I wish I knew this before I purchased shares. I was told that you are not allowed to short an IPO. I was under the assumption that the Nasdaq glitch caused a panic and massive sell off – resulting in even more selling. As to the second day – I have no idea but I am guessing shareholders have lost interest.

Guess the average investor is not as stupid as the investment bankers would like to think. Some time down the road history will show the FB IPO to be the biggest joke ever pulled on the investment community. The only hope for that not happening is if Zuckerberg actually smartens up and brings in a real CEO, but then again this is the guy that has no respect for other people and shows up at meetings in a hoodie…what is he trying to prove…that’s he’s a rich white kid who wants to be rapper running a billion dollar company!?!?!?

Second, the shares available to the public have little voting rights? Why would you buy into a company if you have no say in how it runs.